The recent unanimous decision of the United States Supreme Court (the “Court”) in Clark v. Rameker, 573 U.S. _____ (2014) held that inherited IRAs do not constitute “retirement funds” within the meaning of section 522(b)(3)(C) of the United States Bankruptcy Code. Consequently, inherited IRAs are not exempt from creditor claims in bankruptcy proceedings. The Court’s holding highlights the importance of sound financial and estate planning to protect inherited retirement plan assets from claims of a beneficiary’s creditors.
Traditional and Roth IRAs are governed by sections 408 and 408A of the Internal Revenue Code (the “Code”), respectively. To ensure that both types of IRAs are used for retirement purposes and not as general tax-advantaged savings vehicles, withdrawals from both types of IRAs are subject to a 10 percent penalty if taken before the account holder reaches age 59 1/2.
An inherited IRA is a traditional or Roth IRA that has been “inherited” after the original account holder’s death. If the heir is the account holder’s spouse, the spouse may “roll over” the IRA funds into his or her own “rollover” IRA, or he or she may keep the IRA as an inherited IRA. If an heir does not take regular taxable distributions as a beneficiary, then an heir other than the original account holder’s spouse may only hold the decedent’s IRA as an inherited IRA. Unlike other IRAs, an individual may withdraw funds from an inherited IRA at any time, in any amount, with no tax penalty. Moreover, the owner of an inherited IRA in fact must withdraw the entire account balance within five years of the original owner’s death, or take annual minimum distributions.
Clark v. Rameker Decision
In 2001, Heidi Heffron-Clark inherited a traditional IRA account from her mother worth approximately $450,000 and elected to take monthly distributions. In October 2010, Heidi Heffron-Clark and her husband filed a Chapter 7 bankruptcy petition, and identified the inherited IRA, then worth approximately $300,000, as exempt from the bankruptcy estate pursuant to 11 U.S.C. § 522(b)(3)(C), which exempts from the bankruptcy estate “retirement funds to the extent those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457 or 501(a) of the Internal Revenue Code”.
The Bankruptcy Court denied the debtors’ claim that the inherited IRA was exempt as a retirement fund, reasoning that an inherited IRA does not contain any person’s retirement funds because unlike a traditional or Roth IRA, the funds are neither segregated to meet the needs of, nor distributed on the occasion of, anyone’s retirement. The District Court reversed, interpreting the exemption statute to shield any account containing funds “originally” “accumulated for retirement purposes”. The Seventh Circuit reversed the District Court, noting the difference in rules governing inherited IRAs and ordinary IRAs, and concluded that “inherited IRAs represent an opportunity for current consumption, not a fund of retirement savings.” The Supreme Court granted certiorari to resolve a split between the Fifth and Seventh Circuits and, in a unanimous decision, ruled that inherited IRAs do not constitute “retirement funds,” and therefore are not exempt from the bankruptcy estate.
The Court began its analysis by noting that the Bankruptcy Code does not define the term “retirement funds” and thus interpreted the term in accordance with its ordinary meaning, meaning a sum of money set aside for the specific purpose of retirement.
Looking to the objective legal characteristics of the inherited IRA, rather than the debtors’ subjective motivations and purposes, the unanimous Court identified three characteristics of inherited IRAs that compel the conclusion that inherited IRAs are not objectively set aside for retirement:
- First, the income tax rules governing inherited IRAs prohibit additional contributions by the account holder-heir, whereas traditional and Roth IRAs both provide income tax incentives for account holders to make regular contributions over time to their retirement savings.
- Second, holders of inherited IRAs are required to withdraw money from the accounts, regardless of how many years they may be from retirement. The Court noted that these income tax rules governing inherited IRAs, which diminish their balances over time, regardless of the account holder’s proximity to retirement, are inconsistent with the concept of an account set aside for retirement.
- Finally, the holder of an inherited IRA may withdraw the entire balance at any time, and for any purpose, without penalty. In contrast, early withdrawals from traditional and Roth IRAs carry a 10 percent penalty, subject only to narrow exceptions.
The Court thus characterized an inherited IRA as a “pot of money that can be used freely for current consumption” and “not funds objectively set aside for one’s retirement”.
The Court found further support for its ruling on policy grounds, noting that the bankruptcy exemptions serve the important purpose of protecting debtors’ essential needs, including helping to ensure debtors will have funds to meet basic needs during retirement years. The legal limitations on traditional and Roth IRAs, however, ensure that debtors who hold such accounts but have not reached retirement age do not enjoy a cash windfall by virtue of the exemption by requiring the debtor to wait until age 59 1/2 to withdraw the funds.
In contrast, if an individual were allowed to exempt an inherited IRA from his or her bankruptcy estate, the inherited IRA’s legal characteristics would not prevent such a windfall, as the debtor would be permitted, if not encouraged, to immediately withdraw the entire account balance to purchase, for example, a sports car or vacation home. The Court concluded by noting that allowing such an exemption would transform the Bankruptcy Code’s purposes of preserving debtors’ ability to meet basic needs and to provide a “fresh start” into a “free pass”.
Clark v. Rameker illustrates that IRA account holders must carefully consider the ramifications of any outright beneficiary designations if they wish to ensure that the funds will remain available for the beneficiaries after the original owner’s death.
For instance, a surviving spouse may elect to “roll over” the inherited IRA into his or her own IRA and presumably enjoy protection from creditors in bankruptcy. However, the inherited IRA funds then become subject to the usual restrictions associated with traditional and Roth IRAs, namely significant penalties for early withdrawals. Consequently, when designating a spouse as a beneficiary, IRA account holders must balance the need for creditor protection against the possibility a surviving spouse will need access to the inherited IRA funds before age 59 1/2.
One alternative is the creation of a qualifying trust, the trustee of which can be named the beneficiary of an IRA upon the original account holder’s death. When properly drafted, such a trust will provide numerous benefits, including protection from creditors, as well as a degree of protection against poor financial decision-making, and involuntary transfers of the inherited IRA funds, such as to ex-spouses and other creditors. Moreover, such a trust may permit minor beneficiaries to become immediate beneficiaries of the inherited IRA funds, without the need for a court-supervised guardianship. On the other hand, a significant downside to trust ownership of an inherited IRA is the compressed income tax rate schedule applicable to trusts. In 2014, trust income in excess of $12,150 is subject to a top income tax rate of 39.6%
Finally, although the scope of Clark v. Rameker is limited to inherited IRAs (i.e., retirement plan assets governed by sections 408 and 408A of the Code), the decision implicitly extends to other types of retirement plan assets, such as 401(k) and 403(b) plans, by virtue of the definition of “retirement funds” contained in section 522 of the Bankruptcy Code.